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Will States Get A Multibillion-Dollar Windfall From Corporate Tax Reform?

If Congress follows the classic approach to revenue-neutral corporate tax reform, it will broaden the tax base just enough to offset the revenue loss from lower rates. Many Republicans, like Ways and Means Committee Chair Dave Camp, are gunning for corporate tax reform with a rate reduction from 35 percent to 25 percent. With this rate change, Congress would need to expand by 40 percent the profits subject to tax in order to maintain revenue neutrality.

Most states have corporate income taxes, and most of them base the calculation of profits subject to state corporate tax on taxable income reported on federal tax returns. If the federal government expands its tax base by 40 percent, these states could see an expansion of their corporate tax bases, and their corporate tax revenues, by 40 percent. According to the U.S. Census Bureau, state corporate tax revenue collections now total about $45 billion annually. With the continuing recovery, this figure will soon easily reach $50 billion. So can the states expect something like a $20 billion increase in tax revenue after federal corporate tax reform?

Money (Photo credit: 401(K) 2013)

The short answer is almost certainly no. Yes, there is potential for significant revenue gains from an expansion of the corporate tax base. Federal tax reform is likely to include less generous depreciation allowances, recapture of last-in, last-out reserves, limits on the excess domestic interest deduction, and tightening of international rules so less corporate profit will be shifted outside the United States. But there are many obstacles to states enjoying an increase in tax revenue as large as 40 percent. Here are some of the most important:

(1) As a practical political matter, Congress is unlikely to reduce the corporate tax rate to 25 percent. A more realistic outcome of 30 percent would require only a 17 percent increase in taxable income to maintain revenue neutrality.

(2) Not all states have corporate income taxes. States without corporate taxes or without business taxes based on taxable federal profits get no benefit from an expanded federal corporate tax base.

(3) Many states have already removed from their tax rules federal tax breaks that would be repealed as part of federal tax reform. For example, after 2004, when Congress enacted a deduction for domestic manufacturing and production, about half the states decoupled from this change. Those states would get no expansion of their tax base from tax reform’s repeal of this deduction.

(4) Despite the tax reform mantra “broaden the base, lower the rates,” many revenue raisers to pay for corporate rate reduction will not expand taxable profits. For example, tax reform is likely to include fewer tax credits and more excise taxes. These changes do not increase federal taxable income. (In fact, they will reduce it slightly because excise taxes generally are deductible and tax credits are often included in taxable income.) Also, if Congress enacts a minimum tax as part of its tax reform, this likely will not increase taxable profits that states use to calculate their corporate tax.

(5) States can legislate away the extra revenue from federal reform. Even in states that automatically incorporate federal law changes into their tax rules, action can be taken to offset any federal action. States could decouple from part of federal tax reform and thereby negate potential revenue gains. A far simpler alternative would be for states to use the extra revenue to pay for a reduction of their own corporate tax rate, as some states did after the Tax Reform Act of 1986.

Of course, the great temptation in many states will be to passively accept the extra revenues the federal government has made available. For state legislators hard-pressed for additional revenue, a tax increase they do not have to vote for is a gift from heaven.

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